Higher interest rates risk another global financial crisis, says OECD | Global economy

Financial markets could fall sharply if stubbornly high inflation forces central banks into further aggressive increases in interest rates, a leading international body has warned.

The Paris-based Organisation for Economic Co-operation and Development said ever-higher borrowing costs could put the global financial system under severe stress and send share and bond prices tumbling, as it expressed concern in its half-yearly update that the full impact of tougher policy was yet to felt.

While slightly upgrading its growth forecasts for 2023, the OECD – which has 38 rich-country members – said the upturn remained tentative and the risks were skewed to the downside.

Helped by falling energy prices, the OECD said it now expected growth across its member states of 1.4% this year, up from 0.8% in its last economic outlook. Its UK growth forecast has been revised up from -0.4% to 0.3%.

“Global economic developments have begun to improve, but the upturn remains fragile,” the OECD said as it predicted that global growth would ease from 3.3% in 2022 to 2.7% in 2023 before rising slightly to 2.9% in 2024.

“One key concern is that inflation could continue to be more persistent than expected. Significant additional monetary policy tightening may then be required to lower inflation, raising the likelihood of abrupt asset repricing and risk reassessments in financial markets,” the OECD said in its economic outlook.

The thinktank said a related issue was that the impact of past interest rate rises was difficult to gauge after a prolonged period when central banks had pegged official borrowing costs at historically low levels. In the UK, the Bank of England’s monetary policy committee has raised interest rates at each of its last 12 meetings, pushing them from 0.1% to 4.5%.

“While a cooling of overheated markets and moderation of credit growth are standard channels through which monetary policy normally takes effect, the impact on economic growth could be stronger than expected if tighter financial conditions were to trigger stress in the financial system and undermine financial stability,” the OECD said.

Clare Lombardelli, the body’s chief economist, said: “Monetary policymakers need to navigate a difficult road. Although headline inflation is declining thanks to lower energy prices, core inflation remains stubbornly high, more so than previously expected. Central banks need to maintain restrictive monetary policies until there are clear signs that underlying inflationary pressures are abating.”

Lombardelli said it was important inflation was “squeezed out of the system” and there were some signs that upward price pressures had started to abate. “There will need to be some more tightening in some countries but we are approaching the peak [in interest rates],” she said. “The financial system is a lot more robust than it was before the global financial crisis.”

The OECD chief economist said it was time for member countries to repair the damage to their public finances caused by the twin shocks of the past three years.

“Fiscal policy played a vital role in supporting the global economy through the shocks of the COVID-19 pandemic and Russia’s war in Ukraine. However, in the aftermath, most countries are grappling with higher budget deficits and higher public debt,” Lombardelli said.

“The burden of debt servicing is increasing and spending pressures related to ageing and the climate transition are building. As the recovery takes hold, fiscal support should be scaled back and better targeted. Energy price support should be withdrawn as energy prices fall.”

In the UK, headline inflation is expected to slow on the back of declining energy prices and to come down close to the government’s 2% target by the end of 2024. Core inflation – which excludes items such as energy and food – is predicted to be more persistent due to strong inflation in the price of services, only receding to 3.2% in 2024.

The OECD said it expected the Bank of England to maintain a tough stance, with the impact of higher interest rates increasingly bearing down on output and inflation. The Treasury’s tax and spending plans would also be restrictive because after borrowing heavily following the global pandemic and Russia’s invasion of Ukraine, the government was “significantly exposed to movements in interest rates”.

Swiftly implementing the spring budget’s measures to increase labour supply, and providing certainty for investment and trade were key to strengthening potential growth, the OECD said.